Manufacturing Costs and the Manufacturing Cost Statement

In a trading business we work out the value of our inventory by just looking at the supplier’s invoice (how much did it cost me to buy the goods?).

In a manufacturing business we work out the value of our inventory by calculating how much it cost us to make the goods.

So in order to calculate how much our inventory are worth we need to calculate how much it cost us to manufacture the finished goods.

Manufacturing costs are divided into three broad categories:

1. Direct materials

These are materials that are directly used in making the product. Also known as raw materials.

2. Direct labor

Direct labor is labor directly involved in manufacturing the product, such as a mechanic. This includes people working with their hands or operating machines used to manufacture the product.

3. Overheads

Other general business expenses attributable to manufacturing the product.

This includes rent (on the factory building), insurance (for the factory building or factory machines), and water and electricity (specifically for the factory building).

The first two costs above taken together (direct materials plus direct labor) are known as the conversion costs of a product.

A manufacturing business normally works out the costs for a unit of inventory by preparing a manufacturing cost statement. This is simply a statement of all the manufacturing costs.

Before we look at this statement we need to go over a few more key terms:

Indirect materials:These are inventories that are used in the manufacturing process but whose cost is insignificant. For example, in manufacturing a car, the nuts, screws and bolts would be indirect materials. Cleaning materials that are consumed in producing a completed, clean car would also be indirect materials.

Indirect materials are recorded separately from direct materials, and actually fall under the category of overheads.

Indirect labor:This is the cost of personnel not directly involved in manufacturing the product, but whose cost forms part of the factory expenses.

Included in this are wages and salaries to factory supervisors, cleaners and security guards. Indirect labor is recorded separately from direct labor, and, just like indirect materials, falls under the category of overheads.

Work in progress:These are inventories that have started the manufacturing process but that are not yet finished goods. An example of this would be a car without an engine or fitted windows.

Raw materials:These are inventories that have not yet been used in the manufacturing process at all. An example of this would be the raw (untouched) copper used to make parts of a car, or wood to make a table. Raw materials are also called direct materials.

Now that we have covered all the necessary terms, here is the statement (shown here specifically for a business using the periodic system of inventory accounting):

To calculate the value of direct or raw materials used in the manufacturing process, we use a similar formula to that used to calculate the cost of the finished goods sold (cost of sales) in the income statement:

When we swap this formula around we get:

We use a similar equation for work in progress:

And once again, when we swap the formula around we get:

The above formulas are the basis of the manufacturing cost statement. Refer back and forth between the formulas and the statement and see how the formulas are actually in the statement itself.

Our last formula above concerning “work in progress completed” is a tricky one to find in the manufacturing cost statement. If you look at the statement, “opening work in progress” and “closing work in progress” are right there, but where is the “total cost of work in progress” this year? The answer is that this is equal to everything in the statement above the opening and closing work in progress. The “cost of finished goods manufactured this year” is the exact same as the “work in progress completed” in our formula.

And that is why the manufacturing cost statement is structured the way it is.

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